Repo Sensitivity Hints Cash Might Not Be So Abundant, BofA Says

(Bloomberg) — Recent elevated rates in funding markets, combined with a lack of bank lending, are fueling concern over lack of plentiful cash in the financial system, according to Bank of America Corp.

The Secured Overnight Financing Rate — the benchmark linked to activity in the overnight repurchase agreement market — jumped five basis points to 4.86% on Oct. 15. The move came as $22 billion of mid-month Treasury auction settlements pulled cash from repo market to finance bond purchases. 

This sensitivity of overnight rates to Treasury settlements and limited bank lending at the end of September even as rates soared is pointing to pressure on available funds. Meanwhile, the federal funds rate has remained virtually unchanged within the Federal Reserve’s target range for the policy rate since July 2023 — notwithstanding monetary policy changes — and suggests abundance of cash in the system. 

“We are focused more on repo versus fed funds for shifts in funding market dynamics and measures of reserve abundance/ampleness,” Bank of America strategists Mark Cabana and Katie Craig wrote in a note to clients published Friday. Repo sensitivity to settlements and limited bank lending  “implies less cash abundance than fed funds stability suggests,” they said.

The Fed has been winding down its balance sheet — a process known as quantitative tightening — since 2022. Market participants are watching closely for clues on when precisely QT will cease, and whether it will end before liquidity pressure grows worrisome. This comes as the central bank’s latest gauge shows the amount of reserves underlying the US banking system remain abundant.

While some recent market turbulence stemmed more from primary dealers’ balance-sheet constraints instead of the Fed’s ongoing QT, it evoked memories of September 2019 when an increase in government borrowing and a corporate tax payment created a shortage of reserves. That resulted in a five-fold surge in overnight repo and a spike in the federal funds rate above the target range, forcing the Fed to intervene by expanding its balance sheet to stabilize the market.

Still, the fact that the 75th percentile of the SOFR fixing was 5.01% on Oct. 2 — which is considered a proxy for bank lending — should’ve motivated banks to take excess cash out of reserves and lend into repo for an 11 basis point spread relative to what they could earn at the Fed — currently 4.9%, according to Bank of America. 

However, there may have been two reasons that didn’t happen, according to the strategists. First was a quarter-end overhang, or institutions don’t have that much excess cash to lend into the repo market. 

“If banks are unable to lend cash in repo, it would suggest a limited backstop to prevent further meaningful upward pressure on repo,” the strategists wrote. 

Another anomaly during that period is cash holdings of foreign banks in the US dropped by $133 billion to $1.084 trillion, which was the lowest level since June 2021. While it was likely related to a typical reduction in money-market arbitrage activity —  on a key regulatory reporting date, it could be a sign that such activity is less attractive with higher rates and less cash. 

“The drop in foreign bank cash holdings implies money market arbitrage is less attractive with slightly higher money market rates and less cash abundance,” according to Bank of America strategists.

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